Wall Street Plays a Risky Game, Again

Wall Street
Wall Street

A month and a half into the new year, all's well on the stock markets. Through the end of last week, the Dow Jones Industrial Average (DJI) had:

  • 19 "up" days.

  • Only 14 "down" days.

  • Overall posted a 6% positive return for the year.

Taking note of the Dow's progress, The Wall Street Journal recently called its performance "eerie ... calm ... too quiet." Indeed, if things keep going at this rate, we're on track for the stock markets to gain more than 50% this year. Dow 18,000, anyone?

Irrational Exuberance: Part 2

That sounds like a crazy number -- even reminiscent of Alan Greenspan's famed "irrational exuberance" comments, back before the Internet Bubble burst in 2000. But up on Wall Street itself, the stock market's steady gains have a lot of folks getting, well, downright exuberant.

At investment banker Brown Brothers Harriman, for example, the stock eggheads are already busy counting chickens. After coming into 2012 with fears of Europe on their minds, BBH says that "the decline in market volatility" has them feeling confident that it's time to take a more "aggressive" approach to the market.

"We had been focused on more traditional 'quality' metrics, but now [that] volatility's come down ... we no longer see strong evidence to support those factors outperforming." Dumping its investments in companies with modest debt and conservative balance sheets, BBH is instead pursuing faster gains in "more economically sensitive companies, such as technology and retail stocks."

But is that really wise? If the smart folks up on Wall Street think it's safe to seek out riskier stocks because the Dow's going up, should you follow their lead?

Earth to Wall Street: Are You Out of Your Mind?

"Dow 18,000" may sound like an attractive number, but here are a few data points for you to think about before buying into Wall Street's flight to high-flying tech and retail stocks.

The Dow Jones has never reached a value of 18,000 points before. Literally. Never. In fact, the highest the Dow has ever gone is 14,093, an apex hit on Oct. 8, 2007.

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Historically, the Dow has averaged closer to a 10.5% annual return over long periods of time. Therefore, if 2012 is anywhere close to an "average" year, we've basically captured more than half the year's gains already, in just the first month and a half.

Valued against the profits that companies have earned over the past 10 years, the stock market is arguably already overvalued. If the average ratio of prices to trailing 10-year inflation-adjusted profits has been 18.7 for the past six decades, our current valuation of 22.3 suggests the stock market is already overpriced by close to 20%.

What's more, even stock market bulls who point to "trailing" year profits as the right P/E ratio to value, and call the market cheap at 15.5 times earnings, still say the stock market is only undervalued by 15% -- not 50%.

Storm Clouds on the Horizon

All of this suggests that the strong gains on the Dow that we've seen so far this year almost certainly won't continue through the rest of this year. When you consider how few gains remain to be had, shifting from safe investments in companies with low debt and sound balance sheets, and instead buying flighty retail and tech stocks, seems the height of madness.

All the more so when you consider the multitude of risks on the horizon, any one of which could shock investors out of their complacency, and undo all the gains we've enjoyed so far:

  • Europe hasn't come close to fixing its government debt mess. (Don't smirk, we haven't either.)

  • Iran's threatening to blow up oil tankers in the Persian Gulf, an event that would shock the oil markets and send gasoline prices soaring (and our economy tumbling).

And these are only the risks that we know about -- the known unknowns. They don't take into account any unknown unknowns circling out there like black swans, waiting to alight.

Wall Street may not want to think about all this. You should. As Sgt. Esterhaus might say: "Hey, let's be careful out there."

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